What Does Tracking Error Mean for Your Money? Greg Blotnick, CFA

Investors who study their index funds closely eventually learn of tracking error – the difference between the fund’s performance and that of the underlying index it follows. Since index funds own the same securities as their benchmark indexes, there should not be much difference.

But aside from knowing that a small tracking error is better than a big one, is this something we should really care about?

“Ultimately, tracking error is one factor among several you should consider when deciding to purchase any index fund.” says Anthony D. Criscuolo, planner and portfolio manager with Palisades Hudson Financial Group in Fort Lauderdale, Florida.

In most cases, tracking error causes an index fund to do worse that it’s benchmark rather than better, and small reductions in returns can add up to significant money over many years of compounding.

And in some cases, the error can be enormous, says Greg Blotnick, a hedge fund equity analyst in New York. He notes the wide tracking error of exchange-traded notes designed to follow the CBOE Volatility index that measures volatility in the Standard & Poor’s 500 index.

The most popular examples are the iPath S&P 500 VIX Short-Term Futures (VXX), the VelocityShares Daily 2x VIX Short-Term ETN (TVIX) and the ProShares Ultra VIX Short-Term Futures ETF (UVXY), he says. These products are designed for intra-day trading and hedging, not as long-term holdings. Some use leverage to amplify results, which can magnify losses.

“If you had invested $400,000 in UVXY when it was first introduced (several years ago) you would have less than $100 today,” Blotnick says.

Despite those examples, ETFs generally have very small tracking errors. That’s because fees are very low, and, since ETFs are traded like stocks, they do not have to buy and sell securities to meet investor purchases or sales, so it’s easier for these products to march in lockstep with their underlying indices.

Actively managed funds typically use market indexes as performance benchmarks. But because their goal is to beat the benchmark rather than mirror it, their holdings may be quite different from the benchmarks’ performance.

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While that’s a cause for concern if the managed fund trails its benchmark, this is simply poor performance and not the same sort of tracking error found in index funds.

“Actively managed funds do not attempt to duplicate an index,” says James B. Twining, wealth manager at Financial Plan in Bellingham, Washington. “Instead, they generally strive to outperform it. In other words, they seek tracking error on the upside.”

So true tracking error is mainly a worry for investors in index mutual funds and exchange-traded funds.

Usually, the chief culprit is the index fund’s fees, or expense ratio – money taken from the fund’s assets to pay for staff and other management costs, Criscuolo says.

“If an index fund operates at full efficiency, you would still expect the fund to trail its underlying index by however much it charges the investor in fees,” he says. “The underlying index has no fees, but the index fund does. All else being equal, a less expensive fund will have lower tracking error.”

Error also creeps in if the index fund does not actually own all the securities in the index it follows, he adds, explaining that this is particularly common in bond funds that include hard-to-get securities.

Human error and plain old luck can also contribute, according to Nicholas Yrizarry, CEO of Nicholas Yrizarry Wealth Management Group in Laguna Beach, California. Rising markets can attract a flood of new investment in the fund, forcing the manager to buy more securities, affecting the fund’s costs, while the index itself does not buy or sell.

“Other common factors that affect tracking error are cash drag, rebalancing frequency of the underlying index, and securities lending by the index fund,” Criscuolo says.

Tracking error can clearly matter to big institutional investors trading very large volumes and fretting over even the tiniest price variations. But what about ordinary investors likely to hold an index fund for years, or even decades, for college or retirement?

Small investors are indeed wise to look for how tracking error may affect their results, Criscuolo says, noting that the simplest way is to look at the fund’s performance over time versus that of its index, figures available on fund company sites and data services like Morningstar.com. The more the fund’s performance lags the index’s, the bigger the problem.

For the past five years, the granddaddy of index funds, the Vanguard 500 Index Fund (VFINX) returned an average 13.38 percent a year, while the S&P 500 returned 13.54 percent, according to Morningstar. That small difference is almost entirely explained by the fund’s 0.16 percent expense ratio.

Meanwhile, the Rydex S&P 500 Fund Class A (RYSOX), tracking the same index, returned just 11.70 percent a year, trailing the index dramatically. The chief cause: a 1.55 percent expense ratio, a whopping charge for an index fund.

Why do people buy expensive index funds with large tracking error when there are better alternatives? Either they’re not looking closely or their advisor has talked them into it. The Rydex fund also charges a 4.75 percent load, or $4.75 for every $100 invested, to cover the advisor or broker’s sales commission. The Vanguard fund, and many from other firms, can be purchased directly from the company with no commission.

Investors who want to get into the details of tracking error can look at figures like R-squared, a measure of how well the fund’s movements track the indexes, and Beta which shows how the fund’s risk compares to that of the index, Criscuolo says.

While tracking error is a minor disappointment with most index funds, it can be catastrophic in extreme cases, and is a window into how well the fund is managed, and whether the fund is providing all the efficiencies indexers promise. With managed funds, it shows whether the managers have drifted away from their game plan. Among funds that are similar in most respects, the one with the smaller tracking error is generally the best choice.

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